Legal Update: Potential Problem for S Corporations Under Newly Proposed Debt/Equity Regulations

June 1, 2016

Quoting President and Shareholder Tom Nichols, two authoritative tax news sources recently highlighted a potential problem for S corporations under the debt/equity regulations proposed by the Treasury Department in April (NPRM REG-108060-15, NPRM 49,692). As noted in the Tax Analysts: Tax Notes Today article titled, “S Corps Want Exemption From New Related-Party Debt Rules,” Mr. Nichols first raised this issue publicly at the May 6 meeting of the S Corporation Committee of the American Bar Association Tax Section.
 
As explained by him at the meeting and in a Bloomberg BNA article titled, “S Corporations: Give Us a Break Under Final Debt-Equity Rules," the regulations let the IRS Commissioner "bifurcate" loans made to an S corporation from other members of a "modified expanded group" so that part of the loan is still treated as debt but part of it is treated as "equity," which would almost invariably cause the S corporation to run afoul of the single class of stock rule, the ineligible shareholder rule, or both.  For larger S corporations, the proposed regulations would impose substantial documentation requirements also, but it is important to note that the "bifurcation" rule would apply to all S corporations, not just large ones.
 
These potential ramifications are notwithstanding the fact that the proposed regulations are intended to address so-called "base erosion," "profit shifting" and "earnings stripping," issues that arise primarily in the international context and have not been identified as a significant issue for S corporations, which by definition must be 100% owned by fully taxable United States shareholders.  As Mr. Nichols noted at the meeting, "We're talking about purely domestic corporations that up until now have lent money back and forth, and probably both the deductions and the income is taxed to an individual shareholder, so there's no tax gimmickry or anything involved."
 
As quoted in the Bloomberg BNA article, Mr. Nichols has pointed out that "a lot of innocent bystander damage" could be avoided by simply adopting the "no-brainer" solution to "Just carve out the issue of S Corporation qualification," because the S corporation regulations already contain an "eminently workable and working set of rules" for determining qualification.  As he said at the ABA Tax Section S Corporation Committee meeting, this would protect "a huge chunk of the American economy" and "there really doesn't seem to be any reason for these [new debt/equity] rules to apply for purposes of determining whether or not a given corporation qualifies for S Corporation status."
 
S corporation taxpayers that are potentially impacted by these new regulations may need to take steps now, because the new "bifurcation" rule will only apply to indebtedness issued after the final regulations are published. Thus, it may be appropriate to finalize certain indebtedness arrangements before the 90-day comment period expires at the beginning of July.
 
Tom Nichols focuses his practice on business entity and tax law. If you have any questions or would like to learn more about the proposed regulations and their impact on S corporations, please contact Tom at tjn@mtfn.com or call (414) 273-1300.
 
If you are a subscriber of Tax Analysts or Bloomberg BNA and would like to view the full articles, please click the links below:

Tax Analyst: "S Corps Want Exemption From New Related-Party Debt Rules"
Bloomberg BNA: “S Corporations: Give Us a Break Under Final Debt-Equity Rules"